How seriously do you take the professional standards section of this examination?&nbsp; I firmly believe that scoring 70%+ on this section can decide whether you pass or fail the exam. Committing to score 70%+ on this topic must be part of your exam strategy.



On the test candidates can expect 36 multiple choice questions from Ethics and Professional Standards – 18 questions in the morning and 18 questions in the afternoon. These 36 questions are from the four readings in the first study session.



The questions will revolve around situations involving firms, government/regulatory bodies, and people – charterholders, candidates, investors, beneficiaries, and so on.



Correct answers will center on your ability to apply: seven professional standards of conduct, and the GIPS. To do well in this section, you will have to depend on both your memory and intuition. The main focus of questions is to interpret the code and standards in the context of specific situations. In many cases, you will be asked to identify violations of the Code and Standards.



Tip:&nbsp;The most conservative choice is not always the correct choice and when local laws differ with the standards, the stricter of the two must be followed.

Study Notes for CFA Level I - Ethics and Trust

Ethics and Trust

Ethics is not a subject of moral discussions alone, but one that has implications in how businesses are run. Unethical behavior has far reaching consequences not just to the person involved but their colleagues, their employers and customers.&nbsp;



Ask Enron, Barings Bank, Satyam Computers or Lehman Brothers.&nbsp;



For customers to rely on investment companies the key factors are expertise and trust. By trust, we mean companies must behave responsibly, have transparent business practices and have ethical practices in place. Ethical behavior goes beyond the purview of rules and regulations. The investment manager will often come across situations where ethical conundrums arise and there are no stated rules or laws to fall back on. A clear understanding of ethical behavior will help in such cases.&nbsp;



To understand what ethical behavior is we must first understand that our actions have consequences on several ‘stakeholders’. They could be individuals or organisations. In the investment industry professionals include customers, colleagues, employers and the communities we work with. All groups may or may not benefit from our decisions but it is important to be fair and transparent with all. One cannot for example fudge investment reports to present a rosy picture to clients. This behavior would fall under the ambit of unethical, since it is a hiding of the true nature of facts, which forms the basis of the client’s decision to make or not make a certain investment with the hope of a certain level of returns. 



Ethics is drawn from the Greek word ‘ethos’ which means character and a set of beliefs that define a group. Ethical principles help us demarcate the good from the bad or good choices from bad choices. They are usually shared beliefs; in our case it would mean our company or the investment industry.&nbsp;



Ethics help us create a balance between self-interest and consequences. Presenting accurate earning reports of investments to clients is ethical behavior, which helps the company. Clients trust investment companies that are transparent in their reports even though they may not be up to expectations. They trust the company more.&nbsp;



Honesty, fairness or justice, diligence, and respect for the rights of others are characteristics of ethical behavior.&nbsp;



Governments, the Securities Exchange Commission, Trade bodies all formulate codes of conduct so that participants play fair. They will often come out with a code of conduct that details how members should conduct themselves during business. This helps the community adhere to a certain common standard. 



When violations occur members are censured or disbarred. This is because an individual endangers the trust and relationships the organization(s) has built over a period of time. The CFA is a good example of a community with a code of ethics. These beliefs are presented in the Code of Ethics and Standards of Professional Conduct (Code and Standards), which are included in the CFA Institute Standards of Practice Handbook. For instance, the Code states that members and candidates “place the integrity of the investment profession and the interests of clients above their own personal interests.”&nbsp;



The Code of Conduct is taken very seriously and the CFA has made it mandatory for members to re-affirm their commitment to ethical practices every year. It also expects members to submit a Professional Conduct Statement every year, for any violation. The CFA Institute initiates disciplinary action against any such violation.&nbsp;

What is Ethics in Business?

What is a profession? The CFA handbook describes it as.&nbsp;



<ul><li>based on specialized knowledge and skills. </li><li>based on service to others. </li><li>practiced by members who share and agree to adhere to a common code of ethics. </li></ul>



A distinction is also made between a customer and a client. A customer has one or several transactions, paying per transaction. A client on the other hand, hires a professional for their skill and expertise. It is a relationship based on trust.&nbsp;



The CFA institute communicates its Code of Conduct. This gives members clarity and a common set of standards. It also increases trust and value for CFA members in the eyes of clients or prospective clients. The CFA Institute Code and Standards are based on the shared principles of honesty, integrity, transparency, diligence, and placing client interests first. Rule-based standards are often narrowly defined, applying to specific groups of individuals in specific circumstances. Principle-based standards, such as those of CFA Institute, apply to all candidates and members at all times regardless of title, position, occupation, geographic location, or specific situation.&nbsp;



The CFA codes and standards help cement a spirit of responsibility and trust in the members. 



<h3>Challenges to Ethical Conduct </h3>



Why is it so important to study ethics or adhere to a prescribed code of conduct in a professional group? The reason is simple but not always understood. The reason is to be able to navigate tricky professional situations with ethical behavior. The first step is to accept that such unchartered territory exists and falling back on an ethics standard is more foolproof than simply relying on one’s goodness.&nbsp;



Members of the investment industry feel that their firms and they are very ethical. However retail investors and the general public trust the financial services industry the least. This is known as the overconfidence bias. In this bias, people tend to rely on their internal moral compass, though it has been proved that many factors lead to unethical behavior.&nbsp;



The second challenge to ethical behavior in professional situations is known as situational influence. This is the impact of the peer group or surrounding environmental and cultural factors that influence decision-making. Sometimes a group behaving ethically will influence a person to behave likewise. However, the opposite is also true. People underestimate the importance they place on their organisations or work groups while making crucial decisions.&nbsp;



Other factors that influence decision-making are bonuses, promotions and hierarchy. It is not unusual to find honest, well-intentioned professionals behaving in an unethical manner because they value these rewards and positions of prestige. This leads to individuals focusing on the immediate and short-term gains, without much thought to long-term consequences.&nbsp;



Another reason professionals often go wrong in certain situations is over-compliance. They go too much by the book rather than addressing what the situation requires. When employees are simply complying, rather than questioning if they are behaving ethically in a situation, things can go very wrong. Again, this is a result of a very short-term view.&nbsp;



In the case of Energy major Enron, the CEO and top staff complied with all accounting norms. Unfortunately, the methods they used were unethical and unfair. They used complex accounting to inflate revenues and hide the true extent of debt. They went ahead with blinders, forgetting that they had a responsibility to shareholders. They were held guilty for criminal conspiracy and were responsible for erosion in shareholder value, large loss of jobs and the beginning of people’s lack of faith in large organisations that seemed to be using the rulebook and not practicing it in spirit.&nbsp;

Ethics and Professionalism

Approving home loans to customers without a proper appraisal to meet loan targets ended up snowballing into a financial crisis in the USA in 2008. A lack of adherence to loan appraisal norms meant several customers who did not have money to fulfill the loan requirements were given them. Financial institutions outdid each other to dole out these loans and pretty soon there was a housing bubble waiting to burst. Each unchecked loan added to this bubble.&nbsp;



In this case as in others where ethical norms are not followed trust is broken forever and huge damage is inflicted on the economy, wherein even players who fulfilled norms and conducted business ethically suffer.&nbsp;



The financial markets are the linchpins of the economy. Investors are willing to put in funds, entrepreneurs are willing to start big projects and householders are willing to make purchases (homes, appliances) based on a well functioning financial ecosystem. The foundation of a well functioning financial market lies in trust. Investors trust finance professionals to make well-researched investment choices for them. They believe that the professionals will use their skills and knowledge to best service them. Financial organisations rely on their employees to be open and transparent with their clients and not promise them the moon. They expect employees will behave ethically and fairly at all times.&nbsp;



Unlike several other industries where there are tangible goods or a clear outcome, the investment business is an ongoing process. Furthermore investors have to take the investment professionals words at face value. It is difficult for them to crosscheck details. This is why a high standard of ethics defines the investment industry.&nbsp;



The expectation from a CFA professional are not technical skills alone, but the highest standards in professional conduct.&nbsp;



Ethical businesses also have lower costs, as they are transparent in their dealings and do not come under the scrutiny of governing bodies and therefore legal cases for violation of norms.&nbsp;



Let us take a look at what happens when firms indulge in unethical behavior. They erode the trust of investors. Even if they have been offering fantastic results, they can do so only in the short run. Investors become vary and stop putting in money. Projects that were relying on funding come to a grinding halt. The economy ends up shrinking, rather than expanding and thriving. 



Professionals lose their jobs and reputation for unethical behavior. Governments are now very hard on economic offenders and several fund managers (for example, Bernie Madoff) found themselves doing jail time for misleading and swindling their clients.&nbsp;

Importance of Ethical Behavior in the Investment Industry

Laws codify ethical action. However, all ethical behavior may not be legal. For instance, citizens may protest an unfair legislation. This is an example of ethical behavior but the law enforcement will not consider such a protest legal.&nbsp;



Whistleblowing falls well in the ambit of ethical behavior. The whistleblower reports illegal practices within the industry or organization. However, the organization to which the whistleblower belongs or the country of which he is a part will consider it an illegal action or even treason.&nbsp;



Laws are important to monitor markets. They help ensure there is no ambiguity with regard to certain actions. Unfortunately, laws by themselves are not enough. They can be narrow in scope. Laws may be sufficient but ethical behavior covers more ground. Ethical behavior is required in every dealing, everyday. It requires judgment that helps reach useful conclusions. Ethical behavior must benefit multiple stakeholders - clients, family, colleagues, employers, and market participants - to name a few.&nbsp;

Ethical vs. Legal Standards

Professionals have busy days and to make sure they maintain ethical behavior, a framework for making ethical decisions helps greatly. A framework helps practioners apply the framework and analyzing the particular circumstances of each available alternative, investment professionals are able to determine the best course of action to fulfill their responsibilities in an ethical manner.&nbsp;



Frameworks help professionals keep a long-term perspective and less of a self-interest perspective. The chances of bad judgment due to overconfidence bias are reduced vastly. Frameworks help avoid unknown unethical dilemmas. It also helps service and explain actions to all stakeholders.&nbsp;



<ul><li>Identify: Relevant facts, stakeholders and duties owed, ethical principles, conflicts of interest&nbsp;</li><li>Consider: Situational influences, additional guidance, alternative actions&nbsp;</li><li>Decide and act&nbsp;</li><li>Reflect: Was the outcome as anticipated? Why or why not?&nbsp;</li></ul>



We can use this framework and apply it to ensure ethical behavior in multiple professional situations. By using this framework continuously one can start identifying possible pitfalls and address them without ethical lapses.&nbsp;

Ethical Decision Making Frameworks

Ethics and Trust in the Investment Profession

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Ethics and Trust in the Investment Profession

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